Now, of course, we don’t have shoeshine boys anymore, but it does look as if social media is building up stocks into a very large bubble. But the question is, if that’s true, what should we do about? It it’s, not necessarily the case that we should sell. All of our equity holdings, so in this video we’re going to look at whether we are actually in a bubble, what’s the evidence for that and what we should do about it now, if you do want to learn more about investing, you can do that very easily By clicking on the link below me and beside me, which will let you learn more about our free weekly market roundup and that way you can learn about economics, but also investing and become a better investor. So now let’s look at whether we’re in a bubble and what to do about it in a bit more detail. This is not a recommendation. If you want advice, tell it to your specific circumstances, seek independent financial advice, so let’s start off by looking at whether we are actually in a bubble. Factset publishes this free pdf every week. Looking at corporate earnings for the s p 500 in the us – and this shows you how many dollars people are willing to pay for every forecast dollar of profit generated by the s – p 500 companies when it’s high. That means stocks expensive when it’s low. It means stocks are cheap and you can always compare it with the last five years to say whether things are looking a little bit bubbly now or whether they’re looking cheap, currently it’s well above the five year average it’s well above the 10 year average and it’s Been that way pretty much since summer of last year after the equity market sell off in march last year, it very briefly fell to low levels compared to the last five and ten years, that’s, the green and blue line, but currently it’s, certainly well above those long Term averages so, certainly by this measure, the equity market in the us is looking very expensive and we can also break it down by sector, so that’s the s p 500 companies based on the industry in which they operate so where i am over here on the Right hand, side of the graph you can see.
The current valuation of financials is also above its five year average and it’s 10 year average, where the current valuation is the dark blue bar the five year average is light blue and the 10 year average is in green. In fact, any of the sectors you look at for the s p 500 are currently above those long term averages. The only difference between sectors is the degree by which they’re expensive so, for example, utilities, healthcare and financials are not hugely elevated compared to their usual valuation, whereas consumer discretionary, and that would be companies like amazon, is hugely above its five year and ten year average. As is information technology, so that would be companies like apple and so is energy, which is interesting because it has bounced back slightly since the big sell off in march last year, but the forecast earnings, certainly haven’t, recovered analysts are still fairly pessimistic on what the forward Earnings will be for those companies as there’s a reduced demand for oil and, if we look across different countries based on another measure created by robert schiller, called the cyclically adjusted price to earnings ratio where, instead of dividing by the forecast earnings, we divide by the earnings. Over the previous business cycle, a period of 10 years and i’ve transformed the data into the percentage of time each country has been cheaper than its current valuation, so, for example, currently the u.s has been cheaper than it is now based on cape 91 of the time.
It’S only been more expensive nine percent of the time taiwan and brazil are also very expensive on this measure, whereas the uk has only been cheaper about a third of the time, and spain and mexico have only been cheaper about a fifth of the time, so it’s, Certainly not true that all countries are expensive at the moment, so if you buy equity in the uk or spain, for example, it’s still looking relatively cheap compared to its history. Based on this measure, robert shill has come up with a new valuation measure called the excess cape yield notice. The axes are reversed here, so cheap is at the top and expensive is at the bottom, and the typical value of cape yield going all the way back over a century is about 3.5 and because real interest rates are so low at the moment, they’re negative. That makes the s p 500, look fairly valued, given those low interest rates and, in fact, the last time that equity looked cheap according to that measure was just after the global financial crisis. But i think what this shows is that there is no single measure which tells us yes we’re in a bubble or no we’re. Not. You have to do a bit of detective work to work out for yourself, whether you think equity markets are overvalued and a good way to do that is to use multiple valuation measures and i’ve made lots of videos about that in the past.
I also think it’s really important for us all to be students of financial history. That way when we do see a bubble come along, we can just look back at previous episodes and say yes. This is a pretty good precedent for where we are now and i’d recommend this book by william quinn and john turner called boom and bust, a global history of financial bubbles, and they go back in history and look at many of those bubbles, some of which we’re Not particularly familiar with, i think, you’ll be surprised at some of their examples, but what’s really useful is that they focus all of that learning into one really nice simple model which they call the bubble triangle, and what they show is that, in many of the bubbles Of the past, you need a combination of these three factors: speculation, marketability and the availability of money and credit. Think of that as kindling. But then the spark that starts the fire is a combination of politics and or technological innovation. So let’s look at the situation. We find ourselves in now using quinn and turner’s framework. Now, possibly the clearest factor of the three at the moment is low interest rates and the availability of credit. If we look at junk bond yields in the us at the moment, it’s never been cheaper for a low credit quality company to fund themselves. Or if you look at mortgage interest rates in the us again, they’re very cheap, because policy rates are very low and that pushes down yields on every part of the credit market.
Marketability refers to the ease by which people can buy and sell financial instruments and, of course, with the advent of robin hood and free share trading. It’S now possible for retail investors to trade very easily. Indeed, and to do that at almost no cost. And if we look at the net inflows into the u.s equity market by retail investors, that’s just normal investors, like you and i over the last week, there’s been about 32 billion dollars. That’S flowed into the equity market in the us that’s, a roughly 10 fold increase into the level of inflows that we saw just as far back as 2019, so we can certainly tick off this part of the triangle as well. I think it’s harder to define, but also quantify whether we’re currently seeing speculation. You might define that as people who buy investments regardless of the price they’re paying and the attitude seems to be that valuation is irrelevant. You just buy a stock because it’s going up. If that’s the case, then you would expect momentum, which is a factor by which you just buy rising stocks to outperform, and the outperformance of momentum has accelerated since the pandemic crash in march 2020.. So personally, i think we definitely seeing signs of speculation and finally what’s the catalyst which has really sparked this bubble. I suppose, when they wrote the book, the pandemic would never have been something that people would have thought could trigger a bubble. But the fact that there’s been a huge amount of fiscal stimulus, the government in the us has actually handed out checks here’s.
What one of those stimmy checks looks like made out to alexander hamilton, plus we’ve got an army of investors who are stuck at home. Who’Ve got nothing better to do than to trade stocks on robin hood, and i think that catalyst has been what’s really driven this bubble to new heights. So personally, i think it’s pretty clear that we are in a bubble. Certainly, this framework shows that all the pieces are in place for a bubble if that’s true, that begs the question: what should we do about it and one option is to buy the bubble there’s a really interesting video which you can find on youtube and, as with All my slides, you can see that the reference is here at the bottom, so that you can google it. But what soros says is really interesting. He says that when he sees a bubble forming he rushes to buy adding fuel to the fire, and he says the only way to avoid investors blowing up these bubbles into ever bigger bubbles is for regulators to step into the market, but what’s really interesting is that He says it’s rational, to buy into a bubble. So how could that possibly be true? Some people have likened markets to a beauty contest. If you want to choose the winner, you don’t actually want to find the person you consider the most beautiful you have to find the person which other people are most likely to consider beautiful, and that means you have to understand how other people think – and this is Why it’s great to listen to jim o’shaughnessy, who says it to be a good investor? You have to understand human psychology.
Now one of our cognitive biases is just the way we think is that we tend to overvalue low probability, but big payoffs, in other words, lottery tickets. If you played a lottery, you’re very unlikely to win. But you still take part because of the incredible payoff that you could get if you do win, whereas we tend to undervalue high probability, events so, for example, an asset which gives you lower payoffs, but with a higher probability, is less attractive to us than it should Be now, if you understand that, then suddenly it makes absolute sense for people to overpay for things like ipos, but also private equity, where there’s a potentially very large payoff. But it comes with a very low probability of success and this graph comes from a classic paper by tversky and kahneman in 1992 and it’s quoted in a paper by nick barbarus and ming huang called stocks as lotteries the implications of probability waiting for security prices and They summarize it quite beautifully. They show that, given this probability weighting, that’s built into our minds, it explains why some investors take a large undiversified position in skewed securities. So these are securities which have a potentially very high payoff, which comes with a low probability, because this makes the distribution of their wealth more lottery like, which is something that we like. And in fact we like these low probability, high payoffs. So much that we’re willing to accept a negative average return.
So it does actually make sense for people to buy into a bubble because they can see this potentially very high payoff, even though they realize that most people lose money during one of these bubble. Episodes particularly the ones that come late into the game that buy at those elevated prices, in fact, there’s a whole index which is created by a company called buzz indexes, called the buzz next gen ai us sentiment. Leaders index they’re clearly better at ai than coming up with snappy titles, but what this does is to monitor many social media channels such as twitter, facebook, linkedin, but also some mainstream media. So the wall street journal, for example, and cnn money. Then it uses natural language processing, algorithms to find which stocks have been talked about in a positive light, and it also looks at certain sources more than others. So if they’ve been more accurate in the past or they have a greater influence, they’ll have a greater weighting in order to push up the ranking of a stock. Then it finds the 75 stocks with the most bullish scores by that measure and then every month the scores are redone so that it’s always being updated. So here you can see the s p 500, since 2015 that’s the red line and then in blue. You can see this buzz next gen index and notice for long periods of time. The buzz index was underperforming, the s p 500, but more recently, it’s absolutely taken off, and i don’t think it’s a coincidence that that out performance is timed to coincide with a huge inflow of new retail investors after the pandemic.
So an index is one thing, but you can’t buy it directly in order to buy it, you need a fund manager that’s going to track the index and that’s exactly what the etf called buzz was doing. Unfortunately, it was created too early and at the time it was created, there was almost no outperformance of the index, so nobody bought into it and eventually the etf was liquidated, but it’s no surprise that now the index is performing better. A new etf manager called vanek is going to create a fund which is going to track that index again, hopefully it’s, not too late to the game and the bubble doesn’t pop before the etf is created. That would be a pity. So, if you’re enjoying this video, please consider supporting us, which you can now do directly via youtube as part of our youtube community, there should be a join button underneath this screen. If you’re, watching on your computer and there’ll be a link in the description, if you’re watching online and then you’ll get a beautifully designed icon next to your name, and we will preferentially answer your questions both in the comments and also during a youtube live session. Another approach to bubbles is to go short the market now in the past, that would have meant borrowing, stocks selling them and then buying them back at a lower price. But of course you don’t have to do that anymore. You can just buy one of these etfs, which gives you negative exposure, they’re called inverse etfs, and they either give you minus one or minus two or minus three times the daily return of a given index.
The largest of them is called sh. It’S managed by pro shares and that’ll, give you minus one times the daily return on the s. P 500, or maybe you want to short the nasdaq in that case, you’d go for psq, which gives you minus one times the daily return on nasdaq, but don’t get me started on these minus two times or minus three times funds. Those are really toxic. I can make another video about that if you like, just ask in the comments, but generally those are best avoided. If we look at the long term returns on those funds, you can immediately see the problem over a five year period. Look at the returns on some of these funds, spxu, which is minus three times the s p 500 return would have lost almost 97 of its value. Even the sh fund, which is just short, the s p 500, would have lost almost two thirds of its value over the last five years. That’S, why passive investing without trading too much and just buying equity does so well markets drift upwards and, if you’re short, the markets most of the time you’re going to lose out. So in this bottom panel you can see the s p 500, going back to just before the global financial crisis and let’s say at this point in 2007 magically you knew that the s p 500 was going to crash well. At that point, you could have bought this sh fund and gone short the market, and that would have made a lot of money, but in order to make that money, you’d have had to sell at exactly the right time and unfortunately, no one’s there to tell us When we’re at the bottom of a market, or indeed when a bubble is about to pop, so if you can’t time the market correctly and let’s face it, we have to be honest with ourselves many of us can’t time the market or detect a bubble reliably.
Then you’re probably going to lose out by being short the market. Now my favorite approach is what you might call the maradona strategy now. I know nothing about football. In fact, i hate watching football, but apparently this was the greatest goal ever and this is actually a quote from mervin king who was using it to describe monetary policy by banks and he describes how maradona ran 60 yards right from his own half through the english Half he beat five players and he scored a goal, but what’s truly remarkable is that he ran in practically a straight line. How was he able to beat five players by running in a straight line? Well, the answer is that he used psychology. The defenders reacted to what they thought maradona was going to do, which is to swerve to the left or the right. So his way to beat them was to overcome their expectations and to run straight for the goal. So i think the way for most people to win in the case of a bubble market is to completely ignore the fact you’re in a bubble at all. I think i’d, rather rebrand it as the teddy strategy after my cockapoo teddy now. This is how teddy spends most of his time. He doesn’t do much. He sleeps a lot of the time, and i think this is how most people should approach investing. What seems very odd is that for investors, inactivity is a virtue.
If you don’t look at your portfolio on a daily basis, if you just buy equity and leave it for decades, you’ll probably get a very good outcome. Of course, there’ll be bubbles along the way, so you can be opportunistic and buy more equity after a crash, but predicting whether we’re in a bubble or reacting appropriately and timing. Our entry and exit from trades is almost impossible. So for most people, the best thing to do is absolutely nothing just like my friend here. So, although it may sound strange doing, nothing is actually a pretty good strategy and it works for a lot of people as long as you don’t sell when equity markets crash for most people that’s going to work pretty well over the decades in which they’ll be investing. This is the kind of topic which we discuss all the time on our slack channel there’s, quite a lively debate about what’s going on in markets all the time and there we can all learn together and if you do want to learn more about our patreon community.